In a recent judgment, Delhi High Court reminded taxmen that the valuation of startups in not an exact science. Taxmen ought not to interfere with valuation arrived at experts in the field unless they can demonstrate the flaw in method adopted for valuation.
However, before taxability, an entrepreneur should understand popular valuation methodology.
Startup Valuation:
India is witnessing a robust trend in startup ecosystem. Angel investors – domestic as well as foreign – are investing in the disruptive ideas. However, when a startup is at pre-revenue or early revenue stage, valuation becomes complex. Discounted Cashflow or DCF is a well-recognized method of startup valuation which do not have track records but has valuation based on business idea & current resources.
Discounted Cash Flow Method (DCF)
DCF is a complex calculation. It considers not just company’s present situation but also take into account future performance of the company.
Value of firm derived by discounting future cash flows to the company by expected rate of return of Equity & Debt holders.
DCF is more relevant also because any decision related to investment is taken considering future return on it & DCF method provides valuation based on future cash flows of the Company.
Broad steps of valuation are –
Step 1: Calculation of Projected Profit after Tax.
Step 2: Add back non-cash costs such as assets depreciation.
Step 3: Subtract cash outflow due to capital expenditures.
Step 4: Subtract increases in working capital requirements.
Step 5: Account for the effect of changes in Debts.
Step 6: Discount the future cashflow for each year at the cost of capital.
Step 7: Calculate and add the terminal value accruing in the final year.
Step 8: Calculate Equity by subtracting debt value.
Step 9: Arrive Value of Equity Share by diving number of shares to value of Equity.
The DCF method is also recognized as appropriate method for claiming relief from Angel Tax provided by DPIIT notification.
Angel tax:
With angel investing came the disruption of Angel Tax – introduced in 2012. Angel tax is levied on the capital that is raised by unlisted or private companies if and when the price of its shared happens to exceed their fair market value. The excess value is considered as income and taxed at 30%.
After many representations, DPIIT issued a notification giving a major tax relief to the start-ups registered with DPIIT. However, the latest Delhi HC’s ruling might be able to extend the tax break beyond DPIIT registered startups as well.
The High Court Ruling:
Facts of case:
- In the case of Cinestaan Entertainment, the company had adopted DCF method to value its shares.
- Valuation was based on information and material available on the date of valuation and projection of future revenue.
- Since the performance did not match the projections, tax department sought to challenge the valuation, on that footing.
Hon’ble Delhi HC observed that:
- One cannot lose sight of the fact that the valuer makes forecast or approximation, based on potential value of business.
- Valuation is not an exact science, and therefore cannot be done with arithmetic precision.
- It is a technical and complex problem which can be appropriately left to the consideration and wisdom of experts in the field of accountancy.
- The shares in the present scenario have been subscribed by outside investors. Indeed, if they have seen certain potential and accepted this valuation, tax department cannot question their wisdom.
Based on above observations, the high court rejected tax department’s claim to levy angel tax on investment transaction.
Valuation is in fact an inexact science dependent on numerous variables and assumption. Recognition of this fact under tax law will go long way in protecting startup ecosystem from unjustified tax litigations.
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